April 04, 2012

CFTC Prohibits Certain Federal Election Event Contracts

The Commodity Futures Trading Commission issued an order pursuant to Section 5c(c)(5)(C)(ii) of the Commodity Exchange Act and CFTC Regulation 40.11(a)(1), prohibiting the North American Derivatives Exchange (Nadex) from listing or making available for clearing or trading a set of self-certified political event derivatives contracts. The contracts are binary option contracts that pay out based upon the results of various U.S federal elections to be held in 2012.

Nadex self-certified the contracts on December 19, 2011, and on January 3, 2012, the CFTC initiated a 90-day review period of the contracts pursuant to CFTC Regulation 40.11(c). As a result of reviewing the complete record, the CFTC determined that the contracts involve gaming and are contrary to the public interest, and cannot be listed or made available for clearing or trading. By a separate letter, the CFTC also requested that Nadex withdraw its self-certification of related rule amendments that were submitted by Nadex to enable trading of the contracts.

The contracts at issue included binary contracts on the following 2012 federal election outcomes: a Democratic Majority in the U.S. House of Representatives; a Republican Majority in the U.S. House of Representatives; a Democratic Majority in the U.S. Senate; a Republican Majority in the U.S. Senate; and ten 10 U.S. Presidency outcomes.

CEA Section 5c(c)(5)(C)(ii) and CFTC Regulation 40.11 prohibit contracts or swaps based on an excluded commodity relating to terrorism, assassination, war, gaming, and activities unlawful under any State or Federal law. The rule provides that the CFTC may conduct a 90-day review of a contract, followed by a final determination.

The Commission found that the contracts involve gaming, noting that a number of state statutes, on their face, link the terms gaming or gambling to betting on elections. Under the economic purpose test, the Commission found that the unpredictability of the specific economic consequences of an election means that the Political Event Contracts cannot reasonably be expected to be used for hedging purposes. The order further found that there is no situation in which the Political Event Contracts' prices could form the basis for the pricing of a commercial transaction involving a physical commodity, financial asset or service, which demonstrates that the Political Event Contracts have no price basing utility.

The Commission also found that the contracts were contrary to the public interest, observing that the contracts could potentially be used in ways that would have an adverse effect on the integrity of elections. For example, the contracts create monetary incentives to vote for particular candidates, even when such a vote may be contrary to the voter's political views of such candidates.

Nadex said in a statement that it was “disappointed” in the CFTC decision, adding that “the public would benefit from having these products traded on a well-regulated exchange, rather than an unregulated offshore venue as currently is the case.” One such venue is Intrade, an corporation operating in Ireland that offers political event contracts, currently including numerous contracts based on outcomes of the 2012 U.S. federal elections.